Reducing the risk factor

on 14 September 2006

Like good stand-up comedy, efficient investment relies on expert timing. Get it wrong and you could end up buying your shares or funds when prices are high and selling when they are at rock bottom.

Expert investment timing requires a good knowledge of economic cycles and the time to analyse stockmarket characteristics – at home and abroad if you are investing overseas. If so many professional investment managers get it wrong, how can any private investor create a win-win situation?

There is a simple strategy, used by professionals and private investors to smooth out the impact of volatile markets, and it’s called ‘pound-cost averaging’ or, in lay terms, a regular savings commitment.

If you set up a monthly savings direct debit for your unitised private pension plan or individual savings account (ISA), for example, you invest the same amount each month irrespective of market movements. Deciding when to invest in order to capture the stockmarket peaks and to avoid the troughs is no longer an issue.

Drip-feeding your money into the stockmarkets and averaging out the price you pay for your individual shares or units in a collective fund can work to your advantage. The average cost of your shares or units may be lower than the average price over any given period.

Provided you stick to HM Revenue & Customs annual limits, you can also make lump sum investments on top of your regular savings arrangement. Regular savings plans also make good sense from a discipline point of view.

If you already take advantage of tax-efficient savings vehicles such as pension schemes and ISAs, you will be aware that each year there is a maximum limit on the amount you can contribute to these tax-efficient ‘wrappers’, which shelter your investment growth from income and capital gains tax.

For pension arrangements, under the new tax simplification regime that came into force in April, you can receive tax relief on up to 100% of your earnings up to a maximum of £215,000. ISAs currently allow you to save up to £7,000 per annum.

If you opt for the ‘self-invested’ pension you can buy individual shares as well as funds but, unless you have a very substantial amount to invest, unit trusts and insurance company funds for example are likely to offer the best route to the stockmarket. This is because they diversify risk for you, holding a range of individual shares on your behalf.

The units you buy in a fund provide exposure to the entire portfolio of companies, which the fund manager selects to achieve the fund’s objectives. For example, a lower-risk UK equity fund will focus on large well-established companies, while a ‘smaller companies’ fund will focus on younger growth companies, which offer the opportunity of higher returns but are also more risky.

Buying units in a fund, whatever its objectives, reduces the risks that apply when you pick a particular company in which to invest and something unpredictable happens to reduce the share price or even push the business into insolvency.

Of course there is also the possibility that investing in this way means that you miss out on some opportunities. If the markets rise suddenly over the year then your investment will grow less through the pound-cost averaging approach than it would if you had invested the whole amount before the rise. It would therefore be sensible to look at pound-cost averaging on a rolling 12-month basis.

But, given the price of units reflects the performance of the underlying shares in the fund, if stockmarkets plummet your unit price will fall too. Many investors will remember only too well the ‘bear market’ of 2000-2002 when the whole UK stockmarket fell, as did most of those overseas. Since the end of that period we have experienced comparatively low inflation and low returns but quite significant volatility, particularly in 2006.

So how does the regular savings or pound-cost average approach work and cushion this volatility? Pound-cost averaging helps eliminate the frustration associated with trying to predict which way share and fund prices are likely to go. Your monthly investment will buy less shares or units when prices are high and more when prices are low.

The result over any 12-month period is that you could potentially purchase your shares or units at a price slightly below the average, as shown in the figures below.

Pound-cost averaging is an old concept but it is very effective, particularly when markets are unpredictable or volatile, as they are at present. This approach allows you to spend your time focusing on the important decisions like asset allocation and a choice of funds.

With a regular savings commitment, you also reduce your investment costs because you are not frantically buying and selling in an attempt to keep ahead of the game. If you invest for the long term, choose funds from financially strong institutions with a disciplined and stable management team.